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Sec. 1031 Improvement Exchanges 

In the past, we’ve discussed the mechanics of standard, “forward” Section 1031 exchanges.  We’ve also discussed reverse exchanges. There is another variation on Section 1031 exchanges.  It, too,  has the potential to be extremely valuable in certain situations. This variation is an “improvement exchange”.  Other names include a construction exchange, or build-to-suit exchange. Improvement exchanges involve the acquisition of property which will undergo some level of construction prior to completion of the exchange.

Similar to Reverse Exchanges

Like reverse exchanges, an improvement exchange is also substantially more complex than a traditional forward exchange.  They are also typically quite a bit more expensive. When you pursue an improvement exchange, it is essential that you procure a capable consultant.  That consultant is there to counsel you through the process and guarantee that all aspects have proper structure. properly. 

There are a number of rules and regulations in the tax code specifically applying to improvement exchanges. In this article, we will go over the mechanics of improvement exchanges in detail.  We’ll identify the requirements which are specific to these types of exchanges. We’ll also highlight the reasons why these exchanges may be beneficial for investors.  

Mechanics of Improvement Exchanges 

As mentioned, improvement exchanges occur when an investor wants to acquire a property that’s either unfinished or not yet even under construction. In this variation, the relinquished property is then sold by the taxpayer.  The facilitator, or qualified intermediary, establishes a single member limited liability company (LLC).  The LLC  takes title to the target replacement property.  Then this property is leased to the taxpayer so that construction can proceed. The holding of the property by the LLC (held by the facilitator) is critically important.  That’s because this allows the funds used to finance the construction part of the exchange.

Post-Construction Transfers

After the construction of the property is complete, title may transfer from the LLC to the taxpayer.  An alternative is to transfer the membership rights of the LLC itself to the taxpayer. Just as with standard Sec. 1031 like kind exchanges, improvement exchanges are subject to time constraints.  Completion must occur within 180 days after the sale of the relinquished property. That means that all construction must be finished and the property must be transferred to the taxpayer within the 180 days.  

An Improvement Exchange Example

This could be a typical improvement exchange scenario.  Suppose that a taxpayer locates a single family rental property in need of significant renovation. The taxpayer decides that this property, one properly restored, will be a more promising investment opportunity than alternatives. This property, unrenovated, has a price of $250,000. The taxpayer’s relinquished property has a value of $400,000. The relinquished property is sold and the replacement property acquired by the LLC.  Afterwards, the taxpayer puts $150,000 worth of renovations into the replacement property. The taxpayer thereafter receives a deed to the replacement property. The taxpayer then receives the replacement property, which has a value of $400,000.  At that point, he or she will achieve full tax deferral, because the property was improved using the exchange proceeds.  

Specific Regulations 

When taxpayers conduct an improvement exchange, they must take into account several tax rules.  These are specific to improvement exchanges. For example, when taxpayers identify their replacement property, they must include its description.  The description of the prospective improvements must be as “practicable” at the time of identification. Problems arise ff the taxpayer receives a property substantially dissimilar from the property in the identification.  That may cause the taxpayer to end up failing to satisfy the identification requirement.  In consequence, the property will not qualify to be used in the exchange.

The IRS determines whether a property is “substantially dissimilar” to a given description on a case-by-case basis.  That is, there is no firm rule which can give definitive guidance in all instances. However, there are rules, and general acceptance of these rules.  One such rule is that the replacement property should have a value of at least 75% of the value of the identified property. 

Reverse Improvement Variation 

Taxpayers who want to conduct an improvement exchange but also need to acquire the target replacement property prior to selling their relinquished property may choose to conduct a reverse improvement exchange. In the reverse improvement variation, the taxpayer simply combines the structures of reverse exchanges and improvement exchanges and follows the rules which would normally apply to each variation separately. Hence, the facilitator establishes a holding company to take title to the property prior to the sale of the relinquished property, and the improvements must all be performed before the replacement property is deeded to the taxpayer.

Time Constraints

Just as with standard reverse exchanges, the relinquished property must be sold within 180 days after the replacement property is acquired by the holding company.  That allows the transaction  to stay within the “safe harbor” set up by the IRS. Reverse improvement exchanges can be quite expensive given the complexity involved, but if a taxpayer is willing to absorb the fees, these exchanges can present a great opportunity to acquire a property most suited to his or her needs. 

The Ideal Replacement Property

Improvement exchanges, though complex and relatively expensive, can be very useful in certain contexts. These exchanges can give taxpayers a fantastic opportunity to obtain their “ideal replacement property” which has all of their desired modifications. When attempting this type of transaction, taxpayers must do a considerable amount of preparatory work.  This ensures that the transaction meets applicable time constraints.  Further, they must also be comfortable with the fact that there is a greater risk of receiving taxable boot with improvement exchanges. No matter what the specifics of your situation, always seek out counsel when conducting an improvement exchange.

Talk With An Experienced New York City Tax Attorney For Help

Here at Mackay, Caswell & Callahan, P.C., our attorneys work very hard to stay up-to-date with tax matters.  That includes Sec. 1031 rules and regulations.  It also includes other developments in the tax field.  That way we can provide effective guidance to our clients. If you have a Sec. 1031 issue or any other tax issue, please reach out.  A top tax attorney in NYC will get started on resolving your issue today. 

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